Month: July 2013

Matt Levine argues that complexity in the financial world “has arisen over time because it responds to actual needs.” The heart of his argument is this:

But many of the main flavors of derivatives, from an economic importance perspective, grew out of traditional banking. Evil credit default swaps were invented by JPMorgan in the Glass-Steagall era, when it was a commercial bank and wanted to hedge its commercial loan book. Interest-rate swaps also have a mostly traditional-banking history, starting as a way to let banks and borrowers hedge the interest rate risks of their loans. These were not risky investment-banking activities that mingled uneasily with good old-fashioned safe banking. They were attempts to make old-fashioned banking safer.

Let’s get some basic facts clear here. Glass-Steagall was formally repealed in 1999. But the Glass-Steagall era ended much earlier. I would argue that it ended in December 1986, when the Fed responded to Britain’s Big Bang by permitting banks to have subsidiaries that underwrite non-government securities.

So both CDS and IRS can easily be viewed as products of the post-Glass-Steagall era. Furthermore, while IRS were indeed attempts to make old-fashioned banking “safer,” it far from clear that those who created them were actually thinking through the consequences of their actions from a macro-economic (rather than a micro-economic) perspective. How the financial world addresses the economy’s “actual needs” is a profound question that merits careful discussion. Not the financial industry’s “whatever is, is right” approach that assumes that financial innovation can only take place to address “actual needs.”

Updated: I altered the language a little for some statements that were phrased too strongly.